Behave
yourself!Behavioral
finance adds 'psychological realism' to an academic discipline
with a reputation for embracing the theoretical

By
Deborah Leigh Wood

Paola
Sapienza and Christopher Polk don't consider
themselves staunch supporters of behavioral finance, which
rejects the popular efficient markets theory in favor of the
belief that behavioral factors associated with decision-making
can cause inefficiencies in financial markets. Nevertheless,
these assistant professors of finance at the Kellogg School
saw enough evidence of this relatively new theory to pique
their interest in discovering whether market inefficiencies
have influence on manager's real investment decisions, such
as capital expenditure.

What they emerged
with in their working research paper, "The Real Effects of
Investor Sentiment," is that misvaluation of stock prices
may influence capital investment. In other words, macroeconomic
output can be distorted by inefficient stock markets.

The authors
say their paper is controversial because it suggests new consequences
when human error and/or market frictions allow stock prices
to get out of whack. Behavioral finance, and more generally
behavioral economics, does have its share of highly respected
proponents, including Sapienza's adviser, Andrei Schleifer,
professor of economics at Harvard University, and Daniel Kahneman,
this spring's Nancy L. Schwartz
Memorial Lecture speaker at the Kellogg School. Kahneman,
professor of psychology and professor of public affairs at
Princeton University, was named the 2002 Nobel Prize Laureate
for his psychological insights into economic science.

Though applications
in finance are relatively new, behavioral theories originated
as long as 30 years ago, growing out of research into the
influence of rewards and punishments on decision-making, conducted
at The Hebrew University of Jerusalem.

Behavioral
finance also has its detractors, chief among them Eugene Fama,
who in the 1960s developed the "market knows best"
theory at the University of Chicago—where he served
as Polk's mentor.

"I haven't yet
told him about the paper," Polk says with a wry smile.

While most behavioral
finance research focuses on "who gains and who loses," says
Sapienza, she and Polk wanted to know about "the real economic
consequences" of overvalued and undervalued stock. Could a
manager of an overvalued company invest in projects that rationally
should be considered as negative net present value (NPV) but
are temporarily in vogue by players in the stock market? Similarly,
could managers of undervalued companies forgo positive NPV
projects because the market is overly pessimistic about their
prospects?

Their interpretation
of anecdotal evidence concerning the online grocer Webvan
drove Polk and Sapienza's early discussions about the real
effects of investor sentiment. Early in its existence, each
time that the startup announced the opening of another $25
million automated warehouse, its stock price increased. Only
later did investors realize that that expensive technology
did not automatically turn a questionable business model into
a profitable enterprise, as evidenced by Webvan's bankruptcy
in 2001, after a short shelf life of two years.

"A CEO may be
concerned about stock prices in the short run, but in the
long run [investing in negative NPV projects] destroys the
company's value, hurting the economy," Sapienza says.

She and Polk found
patterns in stock returns consistent with overpriced firms
investing too much and underpriced firms not investing enough.
Companies that had relatively low investment had stock returns
that were subsequently high (after controlling for investment
opportunities and other characteristics linked to return predictability).
Companies (like Webvan) with relatively high investment subsequently
underperformed. Sapienza points out that this evidence confirms
a link between market inefficiencies and some of the most
important decisions within firms, including "not only how
a firm chooses its amount of physical capital but also how
many people a firm employs and how a firm budgets R&D."

Polk says he and
Sapienza believe most skeptics would at least grant that during
the Internet bubble of the 1990s, many entrepreneurs built
startups based on misleading measures, such as the number
of projected Web clicks, rather than on justifiable financial
analysis such as NPV. From that common ground, Polk hopes
that these skeptics will consider their research as an attempt
to see if similar mistakes occurred in other time periods.

The lesson
for companies focused on the stock price in the short run,
Sapienza says, is that eventually "the market catches
up with you."